The Great Anomaly Of The Corporate Bond Market

by: Shmulik Karpf

We are living in a revolutionary period in the financial markets. Home prices have plummeted, mega-banks have filed for bankruptcy and the status of the euro as a valid currency is hanging by a thread.

These events led to a unique interest environment we are currently witnessing - an environment where 10 year notes of the U.S government pay a measly 1.7% and 30 year mortgage rates are lower than 4%.

Zero interest rate environments are not common, to say the least, and can create various anomalies. One of the greater anomalies we are experiencing today is the terrific anomaly of the corporate debt market.

Is this for real?

Due to the fragile status of countries, European countries in particular, various mega companies now act as de-facto sovereign entities. Those companies have a pile of cash on their balance sheets, a strong earnings power and a very deep business moat. Those companies are now able to sell their bonds at absolutely ridiculous yields to investors hungry for yield.

International Business Machines (NYSE:IBM), for example, achieved a record low coupon of 0.55% when it issued $1.5 billion of bonds with a maturity of 3 years back in February.

In May, IBM did it again. The company sold $600 million of 7 year notes with a coupon of 1.875%. Dealogic, the research group, said the sale was at the lowest rate for bonds of that maturity issued in dollars.

But IBM is not the sole player of this game of "how cheap can you raise money?'. Coca Cola (NYSE:KO) was quick to join too. On March 9th, the company issued $1 billion of 3 year notes paying an annual coupon of 0.75%.

A great bargain for Coke, of course. Investors paid through the nose and are sure to lose money year over year to inflation.

A bond affair

Investors are deeply in love with bonds right now. You can see that by watching the spread between corporate bonds and U.S backed bonds. When the spread is high, it indicates that investors are not rushing to finance corporations. Today, that spread has shrunk to new lows because investors are overly eager to buy bonds. Companies like IBM and Coca Cola are always willing to sell it to them for the right price.

Another indicator to watch is the massive redemption from equity funds and the cash inflow of bond funds. This cash outflow from equity funds indicates that investors are wary of stocks. They have fresh memories of 2008 and of August 2011 and they see no reason to buy stocks. They pick bonds instead and for higher prices. Not a very good choice.

The Great Anomaly

These companies did not rush to raise money. It is the investors who came to them. All of them are highly experienced at managing their debt in the utmost efficient manner.

You might ask yourself what those companies are doing with this fresh new money. This is where the great anomaly enters: They either pay dividends to their shareholders or they buy back stock.

Let me repeat this sentence again. The companies who just raised money on the cheap do not rush to invest in the business or in potential M&A takeovers, they simply pay it out as dividends or they buy back stock. In other words, they believe that money is so cheap and their stock is so undervalued that the interest of shareholders is best served when the company buys its own stock on the cheap.

Alternatively, companies like Wal-Mart prefer to pay dividends out of this cheap money now on the expense of future profits.

What smart investors are currently doing

Smart investors realize that the combination of aggressive buyback programs, together with high dividend payouts, will translate into higher yields. The power of compounding will only enforce the return to investors.

Coca Cola Wal-Mart (NYSE:WMT) Sysco (NYSE:SYY) Hershey (NYSE:HSY) Microsoft (NASDAQ:MSFT) International Business Machines Intel (NASDAQ:INTC)
Forward P/E 16.5 11.9 13.7 19 9.8 11.9 9.7
Operating margin 23% 6% 4.6% 19% 38% 20% 31%
ROE 26% 23% 25% 74% 38% 76% 26%
Dividend Yield 2.8% 2.6% 3.9% 2.2% 2.7% 1.7% 3.2%
Payout Ration 51% 32% 41% 50% 26% 22% 34%

The dividend yields of all those companies are high enough to compensate investors for the extra 'risk' of holding a stock rather than a bond. The low payout ratio provides a margin of safety in terms of dividend payments. Not only that but the steady increase in the dividend payout is bound to make you rich years down the road.

Microsoft, for example, increases its dividend by approximately 10% a year. That means that the current 80 cents a year will turn into $1.6 seven years from now. In 21 years time, the dividend distributed by Microsoft will amount to $6.4. If you buy MSFT today at $30, you are almost guaranteed to make 21% a year on your original investment EVERY YEAR. This is extremely hard to beat.

You will never do one tenth as well by purchasing and holding bonds of those companies.

What you should do right now

The most important thing you should do is avoid wasting your money on hype stocks. I wrote all about it and warned investors back in February. You must first realize that Groupon (NASDAQ:GRPN), Zynga (NASDAQ:ZNGA), Facebook (NASDAQ:FB) and the like will not make you money. They will only make money for their founders and underwriters. You are not likely to take a piece of the action.

Once you realize that, you will diversify your portfolio with the stocks that I mentioned above. Most of them are cheap enough for you to pick up and enjoy the ride.

Warren Buffett, at the latest Berkshire (NYSE:BRK.A) annual meeting said that "Bonds are no good right now". You should also take the hint.

Disclosure: I am long MSFT, IBM, SYY.